FX forwards

Definition

An FX forward is an agreement to purchase or sell a set amount of a foreign currency at a

specified price for settlement at a predetermined future date, or within a predetermined
window of time.

Description

Closed forwards must be settled on a specified date. Open forwards set a window of time
during which any portion of the contract can be settled, as long as the entire contract is
settled by the end date.

Why use an FX forward?

FX forwards help investors manage the risk inhere nt in currency markets by

predetermining the rate and date on which they will purchase or sell a given amount of
foreign exchange.

Using FX forwards, one can:

• Protect costs on products and services purchased abroad
• Protect profit margins on products and services sold abroad
• Lock-in exchange rates as much as a year in advance

Theory

Let T = maturity date of forward

S = current spot price of one unit of foreign currency
ST = spot price at maturity of one unit of foreign currency
X = delivery price of one unit of foreign currency
r = continuously compounded domestic risk-free rate of interest for maturity T
 rf = continuously compounded foreign risk-free rate of interest for maturity T
Pos (position) = number of contracts;
Size (contract size) = the number of units of the foreign currency that can be
bought in one contract.

At time T, the owner of one FX forward contract for one unit of foreign currency will
• Receive Pos × Size × 1 = 1 unit of foreign currency (worth ST units of
local currenc y)
• Pay Pos × Size × X = X units of local currency.
Thus, the value of the forward at time T is ST – X.

These two cash flows have to be discounted to time t, and the price of the foreign
currency must be converted to the domestic currency. The difference between the two is
then the price F of the FX forward contract, i.e.,
F = Pos × Size × [ S exp( − r f T ) − X exp( − rT )]

Example
Consider a South African company that is planning to buy equipment from an American
manufacturer. Current quotes on US dollars (USD), available from a large commercial
bank, are:
Spot 11.4200(R/$)
30-day forward 11.4511
60-day forward 11.4600
90-day forward 11.4750
(Bid-ask spread will be ignored here.)

The company is purchasing equipment costing $1 million and must make the payment in
30 days’ time. The company decides to enter into a 30-day forward contract to buy $1
million at the exchange rate of R11.4511/USD. The counter party to the contract is a
large commercial bank willing to sell this quantity of US dollars to the company. The
company knows today that the equipment will cost R11 451 100 in 30 days. By entering
into the forward contract, the company has removed all the foreign exchange risk from
this transaction.

Here, S = 11.42; X = 11.4511;

30
t = 0; T = ;
365
Pos = 1; Size = 1 000 000; and
assume that r = 0.10; rf = 0.15;

Suppose that the spot exchange rate in 30 days’ time is R11.47/USD. To buy $1 million
would cost the company R11 470 000. By using the forward contract, the company
saved R18 900.

The price the company would pay for the forward is

F = Pos × Size × [ S exp( − r f T ) − X exp( − rT )]
   30    30  
= (1 × 1000 000 ) × 11.42 ⋅ exp − 0.15 ⋅   − 11 .4511 ⋅ exp − 0.10 ⋅   
   365    365  
= R77 297.2662